Selective opportunities include regions and sectors benefiting from megatrends — urbanization, rising middle classes, rapid growth in Asia and e-commerce.
We believe commercial real estate markets will remain stable in 2018, supported by faster economic growth as record-high prices curtail demand in the cycle’s late stage. Global returns are likely to remain relatively flat, but still attractive relative to other asset classes. Selective opportunities may be found in regions and sectors benefitting from megatrends, including urbanization, rising middle classes, rapid growth in Asia and e-commerce.
When will the real estate cycle end?
Entering its seventh year of recovery, the commercial real estate cycle is nearing its end, although we don’t expect a downturn in the next year or two. Capitalization rates — the ratio of net operating income to property value — have fallen to record lows as real estate prices have risen faster than operating income. Although further capital appreciation is unlikely, global economic growth should sustain above-inflation income returns and property values (Exhibit 1). Despite record valuations, there are few signs of bubble conditions that developed at the end of the last cycle 10 years ago. Investors remain cautious in response to high valuations and rising interest rates as central banks unwind stimulus. They are reducing their return expectations as allocations to real estate continue to rise, pushing up prices and depressing yields. Overall, we expect 2018 will be a year of stability for real estate, with supply and demand generally in balance and fundamentals supportive.
U.S. real estate market: Slowing moderately after years of outperforming
After nearly six years of double-digit total returns, the U.S. real estate market is slowing in response to high valuations and uncertainty. Overall, we expect total returns to decline to about 5% to 6% in 2018, from about 7% in 2017. E-commerce should drive strong growth in the industrial warehouse segment, while high-performing, experiential retail properties remain attractive. In multifamily housing, Class B apartments should see strong demand from middle-income renters. The office sector is likely to struggle with declining demand as tenants downsize to open floor plans. Investing in commercial mortgages offers potential to reduce downside risk and improve portfolio risk-adjusted returns, particularly in this late stage of the real estate cycle.
Global real estate: Strategies to address peak pricing and low yields
Strategies emphasizing high-quality real estate, diversification and emerging growth may be effective in addressing the challenges of peak pricing and low yields in the cycle’s late stage. Core office, retail and industrial exposure in prime locations will be important in protecting stability of income as the main driver of returns. Yield premiums in lower-quality secondary markets are too small to compensate for the additional risk. Overall, total returns are likely to be in the 5% to 6% range in Western Europe and up to 10% in Asia.
Diversification strategies have potential to reduce portfolio volatility and improve risk-adjusted returns, while improving resilience in an eventual economic downturn. Institutional investors tend to be underexposed to the Asia-Pacific region benefiting most from structural growth trends — urbanization and rising middle classes — that drive faster economic growth compared to other regions. Core locations in developed Asia-Pacific include Australia, Hong Kong, Singapore, Tokyo and Seoul. Although perceived as higher risk, China offers better long-term growth potential. Beijing and Shanghai, for example, are expected to join the global top-10 cities based on GDP in the next decade. Economic centers Guangzhou, Tianjin and Shenzhen are expected to leap into the top 15 by 2030. In Europe, technology-oriented cities in the Nordic region — Stockholm, Copenhagen, Oslo and Helsinki — may offer better growth potential than more traditional financial and business centers.
Selective global sectors may offer attractive value. Alternative real estate — hotels, student housing, self-storage and health care and housing for the elderly — is likely to appreciate as risk levels tend to be lower than perceived. Although expensive, industrial logistics may benefit from structural repricing with the rapid growth of e-commerce.
Alice Breheny - Global Head of Research - TH Real Estate
Melissa Reagen - Head of Research, Americas - TH Real Estate